11 Jul 2016

How Much Would You Pay To Get $135m In 3 Years

As the New Zealand share market continues its broad rally, it becomes increasingly difficult to find genuine long-term value.   Thankfully, there are still a few candidates.  We think Tower is providing one of the better examples of investor short-termism that we have recently seen.

Tower is currently carrying around $135m of excess capital.   This is partly due to the Reserve Bank of New Zealand’s requirement for insurers that are exposed to the Christchurch earthquake to carry additional capital.  This is in excess of the liabilities already provided for by the company to complete all of the Christchurch claims.  Provided Tower has correctly provided for its claims, this capital will be released once the majority of the claims are settled.  The expectation is that the majority of this might not be until 2016 and this appears to be too far out for most investors to consider it valuable.

In one piece of research we read, the analyst acknowledged that there was an excess of capital but attributed no value to it. The analyst literally left it out of  their valuation calculations!  Really?!  $135m in two years is worth nothing??  How much would you pay to get $135 million dollars in two years' time?

A quick back of the envelope calculation shows that if Tower paid $135m back today, it would be on a historic PE of 10x at $2.20 per share.  That is pretty reasonable, especially when the average NZX50 company PE is 18x.  


Back of the envelope PE analysis

2014 Underwriting Profit $24m
4% Investment return on core capital $10m
Profit before tax $34m
Normalised 2014 NPAT $25m
Market Capitalisation at $2.20 $387m
Less excess capital of $135m $252m
PE 10.0x


Perhaps it is cheap for a reason.  Possible reasons for the low share price might be:

  1. Cost blow-out from the Christchurch earthquake.
  2. Tower's lack of scale.
  3. ANZ book run-off.

If these are the reasons, we think these fears are over stated. Christchurch is now well progressed and heavily provisioned.  The industry structure of Tower's markets (New Zealand and the Pacific) is that of rational duopolies.   Tower is a distant third in New Zealand with approximately 6-9% market share in personal motor, contents and house insurance.  While it might lack some economies of scale, its current level of profitability still enables it to generate a decent return on an optimal capital level of capital employed.  The ANZ alliance book is running off and is causing a head wind for sales growth of about minus 1% per year, but this headwind diminishes every year and the rate is proving to be less than initially expected.

At any rate, with an implied PE of 10x, much of these concerns appear to be reflected in the price. Reduction of some of these concerns is likely to see the price of the business move to a PE closer to industry peers of 12x or better. 

There is also the possibility that the new management team might actually realise the potential of the Tower brand and win market share, directly or through new alliances.  Signs are that the new management team is making positive change.  The national promoter score, a key measure of customer satisfaction, is improving.  Staff engagement is improving, a good sign that positive cultural change is occurring.  Tower is showing itself to be more innovative.  Do not under estimate the power of positive cultural change within an organisation.


Source: Tower Ltd

At a PE of 10x, market share gains are certainly not expected nor included in the current share price.